Roi calculations for notes.

[Andrew O.]

I am missing an understanding or a step in the simple calculation of finding how much ROI I get for my cash with regards to notes.

This is my simple process, which seems to give me whack return figures.

Monthly payment x remaining payments = Total return

Total return/Cost of the note = total interest earned.

Total interest earned / # of payments remaining x 12 = interest earned per year.

If I divide the interest earned per year by the cost of the note (principle) I should get the interest earned on my money each year, right?

I generally have a good grasp of mathematics, I enjoy it, what I am doing wrong in the above has me confused though, for a 12% note I am calculating a yearly return of around 8.5%, which just doesn't make sense.

My math or my undestanding of a concept is off. Please correct this.

Andrew

[Dion DePaoli]

When you invest in notes you do so in one of three types of situations:

1. Premium - your capital investment is more than the amount of prinicipal remaining on the loan. In this case your return will be a portion of the interest from the payments. Generically, if the loan has a 12%, you will be less than that 12% and you no gain on sale in the future and run risks of prepayment and default as barriers to achieve your desired return.

2. Par - your capital investment is equal to the amount of principal owed on a loan. Depending on where the loan is in its life-cycle this will either create a yield equal to or slightly ahead of the interest rate or coupon of the loan. So if the original loan was $100k at 12% and you are buying in with a UPB of $80, you will see a little better than 12%. The return here comes from the interest only.

3. Discount - your capital investment is less than the total amount of principal owed on the loan. In this situation, your yield and return is a function of the interest and the future potential of gain on sale/settlement. So if the borrower owes $100k and you purchase the loan for $80k, the arbitrage between your purchase price and the UPB becomes a portion of your return. Some folks, including accounting folks, have a hard time with this for some reason. When you purchase the loan at a discount, your capital invested is disassociated from the principal balance, in other words, your capital does not amortize like the loan does. Or another way to say it, your capital balance will be less than the borrower's principal balance due to the discounted purchase. In this case you will see yields greater than the interest rate of the loan, again as a function of receiving the borrower's principal portion as a form of you return.

So other concepts for you to think of. In your initial calculation, you assume you will hold the loan to maturity. Maybe you do, maybe you do not, but your return will change depending on when the loan pays to zero, perhaps through a refinance. This is prepayment risk.

Total Return = Net Cash (Yield) + Net Gain on Sale (if any) / Cost

What you are trying to solve was your yield:

Gross Yield = [Monthly Payment] x 12 / Cost (this is gross, as you likely have some form of servicing fee that needs to come out of the payment each month)

The gross yield of the loan you are describing it is 14.42%

Generically speaking, it looks like you are paying more for the loan than what should be the principal balance, provided your numbers are correct. The Present Value of your cashflow is $65,333.90, it looks like you are buying a couple thousand more than the balance. As such the IRR for the investment is 11.44% over the life of the loan, provided all payments are made on time, every time. That is still a bit of a gross number as you likely have more costs than you have included here including purchase costs and cost to hold the asset. That math would make sense as the observation above is true, you are purchasing for more than what is owed so holding to maturity you will come in a little less than the note's interest rate.

This variance can be from the data you have been supplied or have supplied us. If the loan currently has some small forbearance to it, then that will explain why the principal payments fall a little short of your actual investment capital. If not, there is an error somewhere in the data, perhaps you rounded up the interest rate, etc.

In the manner in which you were doing your calculation, which was correctly defined above as incorrect, and I see this often, you were taking your net profit and dividing by the investment term. All that does is divide your profit into pieces. As was stated above, what is missing is the return of the initial capital over time per period, so you no long have a ratio of return on that principal. So if you buy for $69k in 5 years, you will have a portion of your $69k back in your pocket. In your mathematics, that does not occur.

If you want to properly setup a calculation for a note, set up the payments using excel and run from Period 0 (initial investment) to Period X (Investment Term), with each period having a Gross/Net Payment (you should use Net Payment) and then you can run an IRR to get your per period return or add date assumptions and use XIRR and it will bring back the annual. If you use IRR in excel and want to convert to a annual IRR, it is NOT IRR x 12, that is not correct. Correctly, you would use (1+IRR)^12+1.

So you would have a table that looks similar to this:

Period (P) Cash Flow
P0 ($69,108.00)
P1 $820.27
P2 $820.27
P3 $820.27
PX .....
=IRR(Cells P0:Px)
=(1+IRR Cell)^12-1

If you run the loan to 160 periods, you should get the same result 11.44%.

If you use an amortization schedule you can play with how much and when the loan pays to zero if not ran to maturity, this will affect your Return. So you would add the estimated Principal Balance on that period in the future. You can use some other features in excel such as CUMPRIN and reduce the UPB based on that calculation. Point being, you have to follow the curve or Principal Repayment. If you put more principal in than your owed in reality, your return will be inflated.

Hope that helps.